EU financial reform: Some small steps, but no fundamental changes in sight

In explaining the disappointingly slow and small steps the European Union has so far taken, Myriam Vander Stichele underscores the fact that some important elements are missing in the EU financial reform agenda.

THE financial sector rescue operations undertaken by European countries since 2008 have exposed the central role of financial services in European societies. However, during the reform of the financial sector that mostly is decided at European Union (EU) level, the usefulness of the sector and its activities to society and the economy has hardly been discussed.

When high bonuses were again being paid to bankers in the summer of 2009, a more open debate arose about the lack of fundamental reforms and how parts of the financial services sector had outstripped 'their economic and social utility as well as the operational capacity to manage them'. This related especially to 'innovative' and speculative derivatives trading, hedge fund and private equity industry activities, investment banking and 'securitisation'. This debate challenged the desirability of simply propping up a financial system that has 'financialised' the economy by putting high financial returns first, allowed huge profits for a few from financial activities that were not much use to anyone else, and resulted in an unbalanced relation between income from labour and income from capital.

As discussed below, the EU's approach to financial reform has not assessed nor integrated these essential issues. Rather, it takes small steps through a wide range of proposals for new regulations, focusing on removing some risky behaviour that it sees as potential contributors to a financial crisis, while important basic reforms still need to be proposed. For instance, the EU has not yet reformed the speculative derivatives markets that include financial instruments which enable speculation on food, as was the case in 2008 and the summer of 2010, and is only at the initial stages of decision-making on such reform (see upcoming article in Third World Resurgence). This very piece-meal process with many separate new regulations contrasts with the US financial reform act signed into law in July 2010, which covers many issues. The EU decision-making process on financial reform so far has been very slow.

Under the EU decision-making process, the European Commission (EC) first consults and makes proposals for new rules (mostly directives), followed by discussions at, and ultimately consensus between, the European Parliament (EP) and the European Council of Ministers of Finance, which have co-decision-making powers. EU member states then have to incorporate EU directives in their national laws by a certain date. This process results in slow actual implementation of the new EU rules already decided.

In the same way as before the financial crisis, EU decision-making on financial regulation is highly influenced by the political power of the financial sector, which results in regulations with limited impact on the industry. The EU follows the G20 agenda at its own pace, while avoiding putting its financial industry at a disadvantage against the US financial industry and also being under pressure from the US not to disadvantage the latter's industry!

Hedge funds and private equity funds

Hedge funds, private equity and similar speculative funds have contributed significantly to the instability of the financial markets and the quest for the highest financial returns. They have risky and aggressive short-term profit strategies, using great quantities of borrowed money ('leverage') and dubious tax strategies. Hedge funds accounted for over 50% of the daily volume of trading in equities and were among the leading buyers and sellers of speculative and structured financial products related to the subprime mortgages which triggered the financial crisis. The crisis has been estimated to result in up to 40% of companies owned or controlled by private equity funds defaulting on their debts or going out of business.

These so-called 'alternative' investment funds (AIFs) are currently not yet directly regulated or transparent. On 18 May 2010, after months of heated debate and very aggressive lobbying by the AIF industry, the European Parliament committee dealing with financial reform (ECON) adopted its position for a new directive regulating hedge funds and private equity funds, the so-called Alternative Investment Fund Managers (AIFM) Directive. On the same day the European Council of Finance Ministers agreed on a position regarding the draft Directive which differed from the EP position. Negotiations to find a compromise were still not finalised by the beginning of July 2010. Agreement on the new rules might be found by September 2010 and be ready in autumn for adoption by the European Parliament which has the final vote.

The issues at stake in the long-running debate on the Directive, which is subject to disagreement between the political defenders and opponents of AIF interests, include the following:

The 'third country' issue: There is a conflicting view between the Council and ECON, with the former wanting to allow the individual member states to apply their own rules when it comes to giving approval to funds from outside the EU. In contrast, ECON proposes to allow foreign AIFs and AIFMs to get a European 'passport' that would enable them to sell their investment products throughout the EU, but only under the condition that the AIF and AIFM home country has strict rules comparable to EU rules in certain areas. These areas would include the fight against money-laundering and terrorist financing, cooperation on regulation and information exchange on tax issues (e.g. tax evasion), and reciprocal market access.

The problem is that the majority (about 80%) of the AIFMs are based in London and around one-third to a half of all UK hedge funds have a US connection. As it is unlikely that the US will meet EU standards, European investors would have no access to those AIFs in the US. However, the purpose of a strict regulation of  'third country' AIFs operating in the EU was to avoid funds based in tax havens.

Leverage, i.e., the use of borrowings (debt) to finance investment: The Council wants to empower competent authorities to set limits to leverage used by AIFMs in order to ensure the stability of the financial system. According to the ECON proposals, AIFMs could themselves set the maximum level of leverage, which theAIFM would be required to disclose to investors while reporting to national authorities their average level of leverage. National authorities would then monitor the suitability of these levels. The European Securities and Markets Authority (ESMA, formerly the Committee of European Securities Regulators) would have the power to require these levels to be corrected if it considered them inappropriate and could require additional reporting in exceptional circumstances.

Transparency: Besides reporting on the levels of leverage, AIFMs will also be required, under the ECON proposal, to provide information on the past performance of the AIF, the ways fees are paid, the amounts paid to the AIFM, the domicile of underlying funds in cases involving 'funds of funds' (umbrella funds investing in more than one hedge fund) and the domicile of any master fund. The authorities would be allowed to ask for additional information from managers who they consider may pose important risks, and in order to protect the stability of the financial system.

Regulation according to the type and size of AIF: After concerted lobbying efforts by the AIFs that they include different types of funds, the ECON and Council draft texts put forward a system which applies different levels of regulation according to the type or size of a fund. It will be the member state authorities which will establish who qualifies for lighter treatment on the basis of the new Directive rules. Private equity funds, investment trusts and non-systemically important AIFMs will be able to avoid full implementation of the Directive. Other types of funds will be completely excluded from the scope of the Directive, such as holding companies, and banks and pension funds only investing their own money. Also, funds with managed assets below 100 million euros, and that use leverage and possess assets below 500 million euros, will not be subject to full regulation.

Less risk: In order to reduce risk, ECON proposes, amongst others, new rules on remuneration that discourage excessive risk, requirements to disclose information about short-selling, prohibition of naked short-selling and a provision that ESMA may decide to restrict short-selling activities in exceptional circumstances or to protect the financial system's stability.

Dealing with 'asset stripping' by private equity funds: Asset stripping relates to private equity funds that dump the debt incurred to buy a company on the company itself, often resulting in cost-cutting and sacking of workers. ECON proposed to avoid such situations by requiring that the company owned by the funds must have capital which is in line with the requirements on capital adequacy established in already existing EU company law. In addition, an AIFM has to notify the relevant authorities and the investors when it has more than 10% of the voting rights of a non-listed company. Also, the AIFM must provide information on the communication policy with employees, on plans for conflict resolution, and on decision-making about business strategy and employment policy, and AIFMs must give notice of any planned divestment of assets.

The UK government has consistently opposed the substance of the draft AIFM Directive because London hosts the majority of AIFMs in the EU, which have heavily lobbied against all regulation. The UK argues that it is best placed to regulate an industry in its territory and points to misunderstandings about the role of depositories and the calculation of leverage. While the new UK government understands it cannot wholly oppose regulation of AIFMs, it still attempts to protect the interests of the UK AIF industry in diplomatic ways. Other EU governments have also been willing to water down the proposed AIFM Directive, including the Czech Republic, which has no hedge fund industry. However, during the Euro and Greek crisis, it became clear to many governments that AIFs contribute to excessive and irrational volatility and speculation in the financial markets. For instance, the crisis shocked German decision-makers, resulting in Minister of Finance Wolfgang Schuble stating that modern financial markets have an 'inherent tendency towards instability'.

Derivatives trading

The derivatives markets are a major part of the financial casino and do not always hedge against price instabilities as often claimed. Trading in derivatives, estimated in June 2008 at almost $700 trillion in notional amounts outstanding (value of the underlying assets of the derivative contracts), is non-transparent even for supervisors, as around 85% happens 'over the counter' (OTC) and not on exchanges. The riskiness of complex derivatives and the interconnections between traders were at the heart of the financial crisis and their non-transparent markets contributed to the halt in lending.

By launching a public consultation paper on 14 June 2010 entitled 'Derivatives and market infrastructures', the European Commission is only at its first stage of regulating derivatives, covering, amongst others, credit default swaps (CDS), foreign exchange derivatives contracts and commodity derivatives (which include food and energy commodities and carbon emission allowances). The proposals aim at:

*  more transparency (for supervisors) including through databases or 'trade repositories' that have all the trade information on outstanding derivatives contracts, and

*  less risk by ensuring that more derivatives are handled by well-regulated so-called central counter-parties (CCPs, which provide financial buffers in case of payment defaults). Companies that use derivatives to protect themselves against price instability ('hedging') would not have to use CCPs when not exceeding a certain amount.

These proposals do not deal with particular problems of speculation on commodity markets, such as prohibiting financial speculators from holding more than a certain number of derivatives contracts. Later in 2010, the EC will hold other consultations and intends to propose EU regulatory legislation on all these issues.1 In addition, the EC proposes that new legislation on better capital requirements (see below) include higher capital requirements for lending by banks to traders of OTC derivatives.

Short-selling and abuses in derivatives markets

In addition to regulating derivatives markets themselves, EU institutions and member states have focused on market abuse and excessive speculative practices which were seen as exacerbating the Greek debt crisis and the Euro crisis in May and June 2010. The EC has launched different initiatives, in particular on short selling and naked credit default swaps, and is under pressure from member states to regulate more quickly, among others from Germany.

The EC has launched a public consultation in which it proposes different options on how to deal with risks from short-selling. The options include more transparency and risk mitigation requirements, and giving supervisory authorities the power to temporarily restrict short-selling and CDS transactions in emergency situations. The EC will present proposals for legislation on short-selling by the end of the summer of 2010.

The EC intends to deal with abusive practices in derivatives markets through the review of the Market Abuse Directive, in order to close regulatory gaps and strengthen the investigative and sanctioning powers of competent authorities. After (public) consultations, the EC intends to put forward legislative proposals to revise the Directive by the end of the year.

Meanwhile, Germany took the unilateral initiative on 19 May 2010 to partially ban trading and (naked) short-selling of CDS linked to eurozone government bonds and in shares of the country's 10 most important financial companies. The Dutch Parliament called for a similar ban at EU level or otherwise at national level for the duration of the German ban. Also in Germany, a draft law on prevention of abuse in securities and derivatives trading was released on 2 June. It contains a prohibition of naked short-selling of German shares and state bonds of the eurozone, and of CDS that have no hedging purposes.

On 8 June 2010, EC President Jose Manuel Barroso was urged by French President Nicolas Sarkozy and German Chancellor Angela Merkel to consider 'prohibition of naked short-selling of all or certain shares and sovereign bonds, as well as of all or certain naked sovereign CDS'. Naked CDS are said to have been used by speculators, although research for evidence still continues and banks owning bonds might have been the main buyers of CDS. High prices for CDS contracts nevertheless forced governments such as Greece to pay more interest on new bonds which CDS are supposed to insure against defaults.

Securitisation

A major financial innovation that triggered the financial crisis was the so-called process of securitisation through which (subprime mortgage) loans and other illiquid assets (e.g. credit card receivables) were pooled together, (re)packaged in complex financial products and sold, often through non-transparent off-balance-sheet entities and tax havens. Since this encouraged risky lending to poor citizens and allowed circumvention by banks of capital reserve regulations, the EU agreed that banks that issue and sell securitised products need to retain a material interest of at least 5% in each of them. This has been criticised by many, including the EP, as insufficient to at least make securitisation less destabilising. In July 2009, the EC made proposals to improve the risk management of re-securitised financial products, rather than forbidding these speculative products, which was included in the Capital Requirements Directive (CRD) (see below).

Protection of citizens

The EU is taking a few initiatives to protect consumers against dangerous and too risky financial products as well as the fallout of a financial crisis. These include:

* Protection against dangerous loans is to be improved through proposals promoting 'responsible' lending and borrowing.

* The setting up of a Financial Services User Group to advise the EC on issues affecting users of financial services such as retail banking, mortgage credit and insurance, as well as to provide insight in implementation of new rules and in other key issues.

* Improving the bank deposit guarantee system across the EU, e.g., with better coverage (all EU savers to be guaranteed up to 100,000 euros), and faster information in case a bank is in crisis, etc.

Bank bonuses and capital requirements

The angry public discussions about perverse banker bonuses have after some time resulted in legal intervention on remuneration at EU level, and after EU leaders had pushed certain principles and binding rules on the G20 agenda in September 2009. The EC's interesting recommendations in April 2009 on remuneration remained non-binding for a while and the EC first proposed only a requirement that banks had supervised remuneration policies of any kind. This proposal was included in an EU revision of the Capital Requirements Directive (see also below) and became much more stringent when the final decisions were taken in July 2010. Amongst others, upfront cash payment of bonuses in banks and investment firms will be limited and at least 40% of such variable remuneration will be paid three to five years later (making changes possible depending on the performance of the bank or investment firm). 

Since the outbreak of the 2008 financial crisis, it has become evident that banks have neither sufficient capital reserves nor liquidity to deal with the risks of sudden high levels of defaults on loans and financial products. Widespread fear that banks would default on loans to each other halted interbank loans and made banks restrict their lending to business and other customers, which significantly contributed to the economic recession and job losses. In addition, a 'moral hazard' resulted from governments using taxpayers' money to prevent a financial meltdown ('socialising losses') created by the risk-laden innovations and strategies that were once a source of huge financial gains to financial operators and shareholders ('privatising profits'). Such moral hazard will remain unresolved so long as banks can continue to become 'too big to fail'. The EC and EU member states consider that imposing higher capital reserves on banks, insurance companies and some financial operators should safeguard the economy and governments from having to pay the price of financial instability and risky products.

The EU has already taken some decisions to introduce new legislation as well as  review legislation regarding different aspects of the financial crisis through different revisions of the CRD. So far, the revisions and proposals have not included measures to ensure financing for sustainable development.

The first EU Capital Requirements Directive (CRD 1) consisted of two directives that were adopted in June 2006, which were a legal transposition of the so-called 'Basel II' accord. Basel II measures are non-binding regulations, proposed by the Basel Committee on Banking Supervision, on how much capital reserves banks must hold when they are lending.

A first review of CRD 1 was decided on 16 September 2009 by the European Parliament and the Council of Ministers of Finance, resulting in CRD 2. The main elements of the changes introduced by CRD 2 were: limiting the use of securitisation, limiting risks of interbank lending, and setting up colleges of supervisors for all cross-border banks headquartered in the EU. National governments and parliaments in the EU are now transposing CRD 2 into their national legislation, which needs to be done by 31 October 2010 for the Directive to come into force by the end of 2010.

The second review of the CRD was finalised in July 2010 and became CRD 3. The main elements of CRD 3 are:

* increased capital requirements for re-securitisations, a financial market practice that contributed to the financial crisis;

* changing the ways by which banks assess the risks connected with their trading books;

* requirements on how banks pay bonuses (variable remuneration: see above).

Finally, the EC and EP are preparing new major revisions of the CRD that will result in CRD 4. The EU process is running parallel to amendments to the Basel II framework proposed (but not yet finalised) by the Basel Committee on Banking Supervision and which the G20 wants to discuss in November 2010. The issues discussed so far at EU level are very similar to those discussed at the Basel Committee, such as how to build capital reserves during good times to cover losses in times of crisis, standards for sufficient liquidity reserves, improving the quality and usefulness of the capital reserves, how much banks can borrow, and how to deal with derivatives trading.

Only after the G20 and the Basel Committee have agreed on such new rules ('Basel III') will the EU start its decision-making process to legislate these issues.

Financial transaction tax

There are many possible methods to fund financial sector losses (and their economic impacts). One such proposal that has gradually gained political support is the introduction of a financial transaction tax (FTT) on all kinds of financial transfers.

However, an April 2010 EC staff working document on 'Innovative financing at a global level' was critical of an FTT, arguing that its efficiency gain was 'by no means certain' and that its compatibility with the EU Treaty 'would need to be further assessed'. In addition, the EC fears that the FTT 'could constitute a breach of the EU's GATS [the World Trade Organisation (WTO)'s General Agreement on Trade in Services] obligations'. The Commission therefore favoured a bank levy instead. It has announced that it would present a legislative proposal on a levy for future rescue funds in October 2010. The European Parliament, in its resolution of 25 March 2010, called for both a bank levy and an FTT, as did the French government.

European civil society organisations are still actively advocating an FTT instead of - or in addition to - a bank levy. They point out that a bank levy would have no systemic impact as risky trading could go on as before. Also, if the money was used as intended, for instance, for a rescue prevention fund, no money would be allocated for the costs of the current crisis and for development needs.

At their summit on 17 June 2010, the EU heads of state agreed that EU member states (except the Czech Republic) would 'introduce systems of levies and taxes on financial institutions to ensure fair burden-sharing and to set incentives to contain systemic risk'. They declared that they wanted the G20 to further explore and develop the 'introduction of a global financial transaction tax' while maintaining a level playing field. However, the G20 took no action towards implementing an FTT at its summit in Toronto on 26-27 June 2010. Nevertheless, the FTT is included in the EU mandate, decided by the Council, for the United Nations' Millennium Development Goals Summit in September 2010. In addition, the EU has announced a task force on innovative financing which includes the issue of an FTT and currency transaction tax (CTT).

Credit rating agencies

In the spring of 2010, credit rating agencies (CRAs) were heavily criticised by EU governments which argued that CRA ratings often do not assess existing problems and are swiftly downgraded only once it becomes clear a financial crisis is looming. Such swift downgrading happened again with the rating of Greece, which had a major negative impact on Greece's capacity to finance its debt, e.g. through the issuing of bonds. Spain, Portugal and Ireland faced similar problems and had to offer high interest rates to those buying their new bonds.

The new EU Regulation on CRAs, which was adopted in 2009 and should become fully applicable in December 2010, includes the following provisions:

* CRAs need to apply for registration (to start only in June 2010).

*  Addressing the risk of conflicts of interest affecting ratings, e.g. by prohibiting a CRA from also offering consultancy services.

* CRAs will need to be more transparent to investors by disclosing the methodology, the internal models and key rating assumptions they use to arrive at their ratings.

On 2 June 2010 the EC proposed small changes for a new CRA regulation, despite major criticism of CRAs. The two main objectives of the EC proposals are:

1) ensuring efficient and centralised supervision of CRAs at European level, and

2) increased transparency on the entities that request ratings to CRAs, so that all CRAs have access to the same information.

The EC admitted that these proposals would not resolve fundamental problems, such as the small number of CRAs and the fact that those to be rated are paying the CRAs (potential conflict of interest). The EC has nevertheless so far not planned to come up with new rules before Spring 2011. On 16 June 2010, the European United Left/Nordic Green Left group  in the EP criticised EC Commissioner Michel Barnier's weak regulatory proposals on CRAs, arguing that it was 'not acceptable for private and self-interested companies to have such a role in evaluating European economies' and calling for the EC to legislate immediately to put an end to this situation.

However, not all EU member governments, such as Germany and the UK Conservatives, are enthusiastic about EU regulation and supervision of CRAs. Yet, due to the Greek crisis, there have been proposals to create a European rating agency that is independent and non-commercial, an idea which German Chancellor Merkel supports.

Financial supervision

The financial crisis has exposed the dangers of the current fragmented nature of European financial supervision, with as many as 80 national and sectoral supervisors responsible for EU-wide cross-border financial operators and products. To improve the situation, the first review of the Capital Requirements Directive (CRD 2) made the establishment of 'colleges' of national supervisors for particular financial conglomerates compulsory.

In September 2009 the EC adopted proposals to significantly strengthen the supervision of the financial sector in Europe. Following the proposals, two new structures will be created:2

* a European Systemic Risk Board (ESRB) to monitor and assess risks to the stability of the financial system as a whole ('macro-prudential supervision'). The head of the European Central Bank (ECB), national central banks, the European Supervisory Authorities (see below), and national supervisors will be part of the ESRB. The ESRB will provide early warning of systemic risks that may be building up and, where necessary, recommendations for action to deal with these risks. However, these warnings may well be ignored during periods of economic growth and kept secret during a crisis for fear of sparking panic.

* a European System of Financial Supervisors (ESFS) for the supervision of individual financial institutions ('micro-prudential supervision'), consisting of a network of national financial supervisors working in tandem with new European Supervisory Authorities (ESAs). The ESAs will be created by transforming three existing financial services committees and will be comprised of national supervisors for three financial market segments:

- European Banking Authority (EBA), replacing the Committee of European Banking Supervisors (CEBS);

- European Insurance and Occupational Pensions Authority (EIOPA), replacing the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS);

- European Securities and Markets Authority (ESMA), replacing the Committee of European Securities Regulators (CESR).

The existing European supervisory committees only had an advisory status, while the new ESAs will have some new mandates such as:3

*   Developing proposals for technical standards, respecting better regulation principles;

*  Resolving cases of disagreement between national supervisors, where legislation requires them to co-operate or to agree;

* Contributing to ensuring consistent application of technical Community rules (including through peer reviews);

* The European Securities and Markets Authority will exercise direct supervisory powers for credit rating agencies;

* A coordination role in emergency situations.

Continued disagreement between the European Parliament and the European Council of Ministers of Finance prevented a full compromise from being reached by the beginning of July for a new supervisory system. Due to this disagreement, the EP did not fully give its final vote on all the new supervisory bodies (although ESMA was approved) in its plenary session of July 2010.  The EU member states seem reluctant to give more supervisory powers to EU supervisory bodies but Council discussions in July 2010 might lead to solutions. If a compromise is reached with the EP after Summer 2010, the new supervisory structure could be in place by early 2011.

The new structure is, however, considered by many to be inadequate to deal with a complex cross-border financial industry while there is no agreed formula on how to share the burden of the costs to rescue European cross-border banks.

Governments trapped in regulatory and supervisory arbitrage

Many important aspects are still missing from the EU financial reform agenda, but also nationally and internationally. For instance, there is no proposal on the official agenda to at least separate commercial banking from risky investment banking. On the contrary, many investment banks were rescued and merged in such a way that they are now deeply embedded into banks that have more than ever become 'too big to fail'. Many other contradictions are also still left untouched; for instance, the EU is pushing to finalise the WTO's Doha Round of free trade negotiations which would include liberalising useless and badly regulated financial services internationally, and implementing the deregulatory rules of the WTO's services agreement (GATS).

The slowness and the weakness of the financial reforms currently on the EU table reflect how national governments, regulators, supervisors and the EC continue to consider it as their task to protect the attractiveness and competitiveness of the financial industries in their respective countries, which are seen as important sources of income and jobs. In the past, the financial sector gained enormous political power by moving to less strict countries, or threatening to do so. As a result, many member states had set regulation and supervision as low as possible and liberalised the financial sector (at home and worldwide), which allowed the financial industry to become 'too big to fail', too interconnected to fail, and to operate many risky financial products and strategies. Now, continued political support for the financial sector through low regulation is conflicting with governments' task to protect the public interest against financial instability, financialisation of the economy, and speculation which increases the gap between the rich and the poor.

Against this continued focus on competitiveness and so-called regulatory and supervisory arbitrage, more political discussions and reforms need to look into the question of what size or model for the financial sector would be economically and socially useful and fulfil the public interest in a sustainable way. The report by France's Commission on the Measurement of Economic Performance and Social Progress, led by Prof. Stiglitz, might be of use to define and promote a financial system that will serve especially those who most need it, reverse climate change, and promote food security and sustainable energy. What needs to be fundamentally changed is a situation where most financial services are focused on the rich, and are about making money from money rather than financing and investing in the economy and society.

More public debates and protests will be needed to press for the integration of the mounting critiques and fundamental issues into the reform agenda. In conclusion, a major overhaul of the EU financial reform agenda is required.                                

Myriam Vander Stichele is a senior researcher at the Netherlands-based SOMO (Centre for Research on Multinational Corporations). The above is an updated and expanded version of the SOMO briefing paper, 'The deficits of the EU financial reforms' (September 2009), co-authored with Thijs Kerckhoffs, which in turn is based on the working document 'An oversight of selected financial reforms on the EU agenda.'

     For more information and updates on the EU financial reforms, refer to the bimonthly newsletter on this issue at http://somo.nl/dossiers-en/sectors/financial/eu-financial-reforms/newsletters.

Endnotes

1    For more information about the EU decision-making processes (EC, Council and EP) see: http://somo.nl/dossiers-en/sectors/financial/eu-financial-reforms/newsletters

2    European Commission, 'Press release IP/09/1347: Commission adopts legislative proposals to strengthen financial supervision in Europe', 23 September 2009.

3    Ibid.

*Third World Resurgence No. 238/239, June-July 2010, pp 25-31